In the “battle of the Bund,” trading of German government bonds shifted from London to Frankfurt in less than a decade. This column analyses that famous financial episode and assesses the potential for new financial exchanges to dethrone incumbents.

When Eurex sought to conquer the US Treasury futures market by taking on the incumbent Chicago Board of Trade (CBOT) in 2004, they referred to their past success during the battle of the Bund. “Yes,” they said, “traders value liquidity in financial markets, and this gives the CBOT an advantage. But history has shown that markets can be tipped away from their incumbents.”

Indeed, back in the 1990s, the newly established Frankfurt-based exchange Deutsche Terminboerse (DTB, the ancestor of Eurex) managed to challenge the London International Financial Futures and Options Exchange’s (LIFFE’s) dominance of the market for the Bund future, one of the most traded futures in the world. The electronic format of DTB, the story goes, provided them with a cost advantage and the ability to attract orders from virtually anywhere in the world. This, together with LIFFE’s sluggish reaction, led to the eventual complete reversal of market share. Figure 1 shows the market share of DTB and LIFFE between 1990 and 1999.

Figure 1: Market share in trading of Bund future

The CBOT-Eurex race looked similar on paper: a floor-based members-owned exchange versus a for-profit electronic exchange and a large interest rate contract. This probably led Eurex’s executives to think they could conquer the US treasury market. Alas, the CBOT also learned their lessons from the battle of the Bund, and Eurex was never able to dent CBOT’s dominance.

Eurex’s failure to enter the US treasury market is not unique. Recent history is replete with exchanges, new or established, who have tried (and failed) to challenge another exchange on their turf. Likewise, in Europe, Mifid has made it easy for market participants to set up their own “mini-exchanges” or multilateral trading platforms. Several have already launched and more are in the works.1 The challenge remains to attract liquidity to the new venture. The battle of the Bund serves as a case study for ambitious executives.

But to what extent can we learn from the battle of the Bund, and what does it tell us about market tipping and competition in today’s financial world? Did Eurex fail in the United States because it faced a more responsive incumbent than fifteen years ago, or because there was something intrinsically different about the CBOT-Eurex competition?

There is one well-understood, although often underestimated, limit to using the analogy to the battle of the Bund to other markets: market organisation, traders, and trading patterns vary across asset classes and, as a recent report by the US Department of Justice argues, some market organisations facilitate competition and entry by challengers, while others create very high barriers to entry.

But, even within the same asset class, there is more than meet the eyes in the battle of the Bund. In recent research, we collected data about members of DTB and LIFFE and about both exchanges’ strategies during the battle of the Bund. Our objective was to understand the determinants of membership at both exchanges: How important was liquidity? Were members responsive to transaction prices? How did access deregulation affect membership? To what extent did the electronic format of DTB confer them an advantage?

Systematic analysis of our data confirms some common interpretations of the battle of the Bund, casts doubt on others, and suggests new lessons.

First, members value liquidity, but some value it more than others and DTB initially attracted traders who valued liquidity less.

Those traders contributed to liquidity on DTB and fostered the creation of a virtuous circle.

Second, remote access deregulation helped DTB, as it was an electronic exchange (unlike LIFFE). However, it was not as critical to its success as often presented.

Third, the German financial institutions that made up DTB’s initial shareholders did help provide liquidity at the very beginning but there is otherwise no sign that nationalism influenced the choice of exchanges and helped DTB.

Fourth, both exchanges were seen as horizontally differentiated and consequently attracted a different set of members. For most of the battle, there was little overlap in membership.

This last aspect is never mentioned in references to the battle of the Bund. Yet, it has huge consequences for competition in today’s world. Indeed, in contrast with the past, today’s financial market participants are largely global firms that are members of virtually all exchanges. The large overlap of exchange members makes it more difficult for a challenger today to garner a critical mass because it has no “captive market.” For example, Eurex US did attract a sizable membership, but all their members were also members of CBOT and had no reason to trade on Eurex rather than on the more liquid CBOT. Differentiation helps counter an incumbent’s liquidity advantage. Such differentiation is harder to achieve today unless exchanges target their market model to a completely different set of traders. In some ways, this is what the multilateral trading platforms are trying to do, and the reason why they are serious threats to incumbent exchanges.